LBS on Central Banks and Deleveraging

This entry was posted
on Monday, February 18th, 2013 at 8:30 pm and is filed under Uncategorized.
You can follow any responses to this entry through the RSS 2.0 feed.
You can leave a response, or trackback from your own site.

Just a few days ahead of the February 24 and 25 elections, the Italian media are ignoring the success of the former comic and self-declared populist. However, according to the polls, Grillo and Berlusconi could give rise to an unprecedented coalition of anti-Europeans.

That analysis makes considerable sense , but, given LBS’s involvement in the financialisation of the economy, the guff about moral hazard rings pretty hollow.

Here’s a relevant persepctive from Doug Noland

‘First of all, we’re seeing important confirmation in the thesis that heightened global fragilities and aggressive policymaker responses have incited only more aggressive risk-taking. There is, as well, support for the view that currency markets have become a key battleground for the speculator community….

…Yet global central banks have created such abundant liquidity conditions that currency speculation seems likely to gain further momentum. In our unstable financial and economic worlds, policy measures have come to dictate currency and risk market behavior. This plays right into the hands of a global pool of speculative finance that – bull market, bear market, crisis or recovery – only seems to inflate larger by the year….

…At the same time, there is also ongoing confirmation that the incredible global policymaking and liquidity backdrop is much more successful in inflating asset markets than it is in boosting economic performance. In particular – and especially considering policy environments – economies in Europe, Japan and the U.S. continue to un-impress. This bolsters the view of a widening global gap between inflating financial asset prices and underlying economic fundamentals.’

“A smart idea, which does not require parliamentary approval, is for the central bank to do the job. By intervening directly in the markets, the central bank can reduce the amount of risky assets in the system in exchange for cash, and decrease interest rates with a view to encouraging economic agents to start borrowing again.”

Mr. LBS esq. makes a fundamental error in this sentence in my view. Central Bank acquisition of risky assets is NOT the equivalent of reducing the private debt burden and subsidising investors and depositors for their consequent losses.

Those private borrowers subject to private debt remain subject to those debts unless banks restructure their debts. In the case of individuals, this will only happen if there is a generous insolvency regime, and even then the transmission device (i.e. the banks) is slow and inefficient.

Furthermore, temporarily reducing the burden on the banks by taking the assets off their books through repo operations does not encourage banks to lend into a distressed market. The banks are in a mexican stand-off amongst themselves as asset prices decline and stagnate and new businesses struggle with reduced success rates. Instead they do their best to deleverage gradually and as surely as possible while the central bank assistance endures.

I suggest that Lorenzo Bini Smaghi, like his Central Bank predecessors in Europe of yore, makes a fundamental error in grossly over-estimating the effectiveness of traditional Central Bank tools in a major crisis.

It is also to be noted that LBS ultimately sees no solutions to this problem. He says those who act properly in keeping an eye on inflation will ultimately have to engage in financial repression to avoid excessive currency appreciation. He goes on to say that this will ultimately lead to more risk taking and another crisis.

Mr. Bini Smaghi appears to have a deep seated psychological fear of moral hazard and ambivalence to risk taking. He wants to encourage economic development which involved risk taking, and yet he is terrified of risk taking per se. He cannot see any middle road of encouraging an optimum or tolerable level of risk taking, much as he does not see that an entire genration has learned its lesson as previously happened after the 1930s. The clearest clue to this irreconcilable pschological paradox afflicting Mr. Bini Smaghi is his omission of the word “excessive” before the words “risk taking” in his final sentence:

“The most likely outcome of the currency peace which would result from a global attempt by central banks to repress holders of financial assets would be a new bout of risk taking all over the world. And, sooner or later, a new financial crisis.”

Methinks we must all congratulate DOCM on demonstrating such admirable restraint, way beyond the call of duty, in withholding his usual fawning admiration and adulation for the epistles of the ‘great one’ and the ideology of lorenzobinismaghiitis.